This is based on a conversation I had with a friend the other day which got me thinking…
Many of us are considering moving to a bigger (or just more expensive) place but the challenge is often having money for the deposit to secure a mortgage. So should one be saving up to buy a more expensive property at a later stage?
Spontaneously it makes perfect sense as you are likely to need a higher deposit to be able to buy a larger home but let’s take a look at a few different examples together and see if the initial reasoning is always correct?
A young couple making around 60k per year (before tax), current flat valued around 130k and 100k in mortgage and hence currently around 30k in equity. As this is taking place in Sweden, I will use our generic numbers here so to buy a home, you would need 15% deposit.
Let’s then say they want to save up so that they can buy a bigger place in 4 years and they are estimating that the property will then cost them a minimum of 400,000 USD. In our scenario, that would mean they will need 60k (15% on 400k) for the deposit but let’s make it 65k including some fees etc.
Now over to a few different scenarios on how this will play out.
1: Start saving for that deposit using a bank account (zero interest…)
Let’s assume no appreciation in values (prices of properties going up) to keep it simple. It means that between the two of them, they will have to save a total of 65k-30k (current equity) which equals 35k. 35,000 USD over 4 years is around 9,000 USD between the two of them.
Based on their annual combined income of 60k BEFORE tax, their take home pay (here in Sweden) is around 60*0,65=39k per year.
Saving 9,000 USD per year out of 39,000 USD gives us a savings ratio of 9/39=0,2308 which means 23%. This is solely for their deposit and not for anything else. It basically means a quarter of their take home pay will have to be saved every year for them to have the required deposit in four years.
Doable? I would say yes. Is this a realistic scenario? Could be, but let’s first have a look at a couple of alterations.
2: They start saving using a high yielding savings account (2%)
We assume everything else is identical to scenario 1 above, then the interest will mean they will have 37,100 USD after 4 years so they can buy a new sofa too when moving in but that’s about it.
3: What if they take a slightly more aggressive approach investing their savings on the stock market?
Let’s again assume everything remains the same as in scenario 1 and they get “lucky” by achieving returns of 8% per year (around the historical long term average on the stock market). That would bring their deposit up to 40,500 USD. Alternatively one could have said that instead of saving 750 USD per month (equals 9,000 USD per year), it would have been enough with around 670 USD per month.
Still not amazing but as you all know by now compounding (interest on interest) takes time and 4 years is not very long in that sense. So if one is saving for a deposit which is intended to be used within the next 1-5 years, the money should probably not be invested on the stock market. What if you get really unlucky and the market goes down with 50%?!
Based on this, the realistic scenario would be some kind of “safe” investments but one actually yielding something and not zero.
So what are we missing??
One thing I wasn’t thinking about initially when having this discussion was inflation (prices going up). So what, you might say. But…
Let’s go back to scenario 1 again, where they save almost a quarter of their take home pay to be able to cough up the intended 65k deposit.
BUT what if we include a 2% inflation? Basically saying that property prices will go up with 2% per year.
Their dream home, which now would cost them 400,000 USD will probably cost a bit more in 4 years. So that house will then cost them 432,000 USD! If they still need the 15% deposit, it now equals another 5,000 USD! Maybe that too is doable but what if they have bad luck and the house they wanted to buy is in an attractive area and prices go up by 4% per year. Then we are talking about 467,000 USD and even if they might be able to save for the deposit, can they now get a big enough mortgage??
In this little exercise I have not taken into account the fact that if the property market goes up, they will most likely also get more money for their flat so there will be a bit of a cushion there. But if you currently don’t own another property and you want to get onto the ladder, well then I would suggest you play around with some numbers like these.
If you want to save 50k for a deposit but you are fighting inflation on an asset worth 8 times as much (400k), you will have to save another 1,2k every year just to keep up with the increase in the property prices!! This again, still assumes you can get an even larger and larger mortgage.
What else to do??
All lenders have restrictions as to how much you can borrow and the amount is often quite similar between different lenders but can also vary slightly. A rough rule of thumb (if you have good control of your money and expenses) is that you can borrow five times your annual income (pre-tax).
So not only do you need to have the required deposit, you also need to make sure that your salary is high enough for you to be able to borrow the amount you want.
With this in mind and the potential challenge of saving up to a large deposit in a rather short period of time, moving to a new employer might actually be a very appealing solution. Unfortunately for most, the harsh reality is that those who are loyal to their employees, make less than those who “jump around”. If you stay with your employer, you salary might increase with inflation, let’s say 2% per year. However, if you move to another company I would say you are likely to increase your annual income more than 10%. Otherwise you would not be moving if the purpose of the move is to make more money.
At the same time, you should always do your best at your current employer to make the most of it and especially if you like your job and the team. If not, you have yet another reason why you should be thinking about moving on.
In today’s times, moving jobs every two years is not that uncommon and if you do that and increase your salary with more than 10% every time, that would obviously have a significant impact on your ability to buy that dream home of yours!
Based on what one is looking at and one’s financial situation and based on the above assumptions and (some) inflation it looks like it might actually be a good idea to get onto the property ladder as soon as possible. Trying to save more money to make up for increasing prices is possibly the most common thing to do but it might not be easy as we have to remember that savings require money after tax. That means that if prices go up by X,000 USD per year, the amount you will have to save in addition to your initial savings is X,000 PLUS your income tax!
So there are a few limiting factors here. One is the relatively short time frame to purchase (only four years) so there really should be no risk taking applied which means no or very low returns on those savings. The other factor is the amount of money one can borrow given one’s financial situation and current mortgage rates (affordability etc).
My conclusion is to try planning ahead and look at different scenarios and what the outcome might be. It for sure is a good idea to try increasing your salary as that can (most likely will) have a very big impact as well, both when it comes to the amount you can borrow and how fast you can save up to the deposit. Maybe it’s even worth while stretching a bit faster and actually move sooner rather than later if you expect prices to rise quite fast in the area you are looking to move to. If you are moving to a low cost of living area, well, good for you!
My two cents of the day!
Actions to take:
- How to prepare for a job interview
- How to nail a job interview
- Savings Ideas!
- Why you should always check the interest on your savings account
- Why you should always be using leverage – wisely!
- Fixed or Floating rate on your mortgage??